The Australian economy has been unfazed by recession for 27 years now and still continues to hold the record for the longest stretch of economic growth in modern history. The country’s economic resilience has been the envy of many as they have breezed through the global financial crisis, Asian financial crisis, dotcom bubble and the great recession. Since 1992, Australia’s growth averaged at 3.2% per year which is well above that of other major developed economies. According to the ABS, majority of the growth for the past few years has been spurred by household expenditure. As with the trend of increased household consumption, concerns about an elevated level of private sector debt has also been looming. Is this worth a worry or is it just testing Australia’s economic resilience? This paper attempts to answer the question: Does private sector debt cripple any prospect of long-term growth?

Get Help With Your Essay

If you need assistance with writing your essay, our professional essay writing service is here to help!
Find out more about our Essay Writing Service

II. Australian Private Sector Debt Environment

A huge part of the Australian economy is financed through debt and it undoubtedly still continues to play an integral part of this country’s economic progress. Growth has been driven partly by debt as households and corporates utilize credit for capital intensive purchases or basically to generate more wealth.

Private sector debt are obligations undertaken by the private households and firms in an economy. This can take numerous forms such as mortgages, investor debt, personal loans, credit card, corporate bonds, overdraft and business loan.

Household debt is simply the total amount of money all adults in the household owe. Based on the data from ABS last 2014, Australia’s household debt composition is described in the chart below. Mortgages on owner-occupied houses (56.3%) captures more than half of the total household debt while investor related debt (36.5%) takes the second spot.

Chart 1 Source: ABS (2015) Survey of Income and Housing 2013-14 and AMP.NATSEM (Dec 2015)

The chart below lays down the division of private sector debt and focuses on the continuous increase of loans with the household sector eventually surpassing the loans provided to businesses.

Chart 2 Source: Australia’s Debt: An Honest Debate

After businesses tanked in the stock market collapse in 1987, Australian banks shifted their focus to pumping money into property by encouraging home loans. In 2009, 60% of the portfolios of the banks in Australia consist of residential loans while the US and Canada carries 40% and the UK only has 15% (Stewart, Robertson, Heath, 2013). The substantial increase in the household’s sector leverage over the years has brought Australia’s level to be at par with most advanced economies. This was enabled by the decline in interest rates in an attempt to spur economic growth and inflation by making it very cheap for people to borrow and invest. Another factor that contributed to the sharp rise in Australia’s home loan sector includes easing in credit constraints in response to financial deregulation and increased competition among lenders (Kent, Ossolinski, Willard, 2007). As evidenced by the chart above, the share of total housing debt increased from 25% in 1990 to more than 60% in 2016 which came at the expense of productive business lending.

The decrease in business sector growth was a result of the strong increase in external funding already raised during the late 1980s. Businesses also had to reevaluate their gearing positions after the recession in the early 1990s (Stewart, Robertson, Heath, 2013).

Personal loans account for only a small share of total household debt. This comprises the borrowings made by households not related to residential or funding unincorporated businesses. It is also important to note that the ratio of non-performing personal loans has been in an upward trend throughout the years driven by credit card and other personal debt but this is not an indication of an overall deteriorating household health. According to the April 2018 Financial Stability Review by the RBA, this rise just reflects cyclical effects of economic conditions in mining-exposed states and structural changes in lending markets.

On the funding side, Australian banks fund only three-fifths of their liabilities through deposits while around 35% is sourced through wholesale funding. Compared to its international counterparts, Australia uses offshore funding more. Low bank deposit levels do not imply a low share of household financial assets as the share of Australian superannuation assets invested in deposits is more than double the median asset allocation share for a number of OECD countries (Stewart, Robertson, Heath, 2013). A large share of household debt demand was serviced by the banking sector through offshore funding as most do not have direct access these markets. This allowed banks to diversify their sources but also gave them the additional task of hedging their foreign currency risk. Based on the data last 2013, around three-quarters of funds are hedged back into Australian dollars as a protection should the AUD depreciate. According to RBA’s October 2018 Financial Stability Review, Australian banks have completed their transition to a more resilient funding model by increasing their deposits funding while reducing their short-term wholesale debt. In addition to that, banks are also actively managing their future refinancing needs by extending the maturity of their debts. According to Chart 4, the weighted average residual maturity of their long-term debts was extended from 3 to 4 years.

Chart 3 & 4 Source: RBA October 2018 Financial Stability Review

III. Household Sector’s Debt Sustainability

A. Household Debt to Income

Since businesses’ debt profile have been decreasing, much of the focus is in households’ staggering debt increase. Relative to other developed countries, household debt in Australia is significantly high. Due to the low interest rate environment discussed earlier, people took advantage of the opportunity to take out larger and more flexible loans to buy the house they desired. As seen in Chart 5, the ratio of total household debt to income had a steep increase in the past decade alongside other countries such as Canada, Sweden, Norway and New Zealand. It is also worthy to note that the left hand side of the chart are the countries that were more resilient to the effects of the financial crisis while the right hand side were the countries that were more affected resulting to deleveraging and a lower ratio than the rest. Debt to income measures the percentage of income that is allotted to repayments and Australia’s household debt is around 1.9x the amount of its income. They own debts almost twice as much as they earn.

Chart 5 Source: RBA April 2018 Financial Stability Review

B. Demand and Supply

In Australia, a positive relationship between household income and demand for houses exists such that income elasticity of demand is likely to be one or greater (Berry, Dalton, 2004). According to Abelson, Joyeux, Milunovich and Chung (2005), the estimated long-run elasticity of real house prices to disposable income is 1.71. This means that if income increases by 1%, house prices will increase by 1.71%.

Also, the more people borrowed money, the more real estate prices rose to meet the increased spending power of buyers. In addition, there is a constrain in the supply of well-located houses due to zoning issues, geography and inadequate transport therefore, pushing prices even higher as supply became scant (Lowe, 2017). Population growth as well as credit demand for speculative housing investors also caused prices to continue its upward trend.

Looking at Chart 6, household liabilities have been driven largely by owner-occupied housing debt while investor housing remained almost unchanged from 2006 relative to disposable income. As discussed above, value of assets and liabilities rose throughout the years driven by the increase in real estate prices. The balance sheet portion of the chart also shows that for most households, value of the assets exceeds that of the liabilities; however, majority of their wealth such as the house and superannuation are considered as rather illiquid.

Chart 6 Source: RBA October 2018 Financial Stability Review

C. Risks – Wage Growth and Unemployment

Growth in household debt has been outpacing income and asset growth since 2003 which is why the debt to income ratio in Australia has been creeping up. If wages fail to pick up and debt continues to grow, financial stress can arise on the back of households’ inability to service repayments with their income. Given the high debt burden, it is likely that households could trim down their spending should economic conditions suddenly go sour. A sharp contraction in household consumption can happen as they realize that they have already borrowed too much and try to get their balance sheets back into better shape. Therefore, a slowdown in income growth can directly impede the country’s growth making it more susceptible to shocks.

Another kind of financial stress that households may encounter is unemployment. The level of mortgage debt that was once manageable when it was first taken out might become unmanageable if the income earner suddenly loses his job. This translates to a sudden drop in income leading to failed repayments and essentially a decrease in consumption.

A person can liquidate the house if he fails to make repayments; however, this would entail a wider negative impact if it is brought about by a widespread difficulty to pay, rise in unemployment and households wanting to sell immediately. When panic is magnified, prices could immediately drop while the debt underpinned in those assets remain fixed. At present conditions, households in aggregate are still well-placed to service their debts (RBA 2018).

D. Distribution of Debt

The household debt to income ratio measures the capacity of an average Australian to repay its debt using its income. One important factor to consider in the analysis of this ratio is the distribution of debt. This focuses on who will likely get into trouble when things go bad which is not the average Australian. Looking at Chart 7, the rise in the household debt to income ratio is most prominent in the 4^th and 5^th income quintiles. This is contrasted to what occurred in the United States where many of the borrowers were in the lower income bracket thus leading to the subprime mortgage crisis. In the case of Australia, the increased borrowings came from the wealthier citizens hence, they are more insulated to shocks and have more capacity to sustain their debts.

Chart 7 Source: RBA Speech Household Debt, Housing Prices and Resilience

IV. Growth

A. Private Debt to GDP

Private debt to GDP ratio measures the capacity of the country to pay for the total household debt. Taking into consideration the worst possible case and that the private sector defaults on their repayments, how much of the debt can be covered by the government’s income? A higher ratio doesn’t necessarily mean that it’s bad. It is acceptable if the buyers of the debt are domestic which means they can spur economic activity; however, if growth slows down, the country might find it more difficult to repay their debts. In the case of Australia, the RBA has curbed demand for debts by implementing tighter borrowing standards in 2015. This has initially tempered the amount of debt and as expected, contracted the GDP. Recently, growth has picked up fueled by consumer spending financed not by debt but by shrinking household savings which indicates an increased consumer confidence in the government.

Chart 8 Source: Trading Economics, OECD

B. Factors Affecting Growth

1. Monetary Policy and Interest Rates

The housing sector is very sensitive to changes in interest rates as compared to the economy as a whole but the degree varies through time and across countries (Berger-Thomson, Ellis, 2004). Essentially, a direct effect of monetary policy can be seen in the cost of housing. If short-term interest rate is raised, long-term rates will tend to follow suit sending mortgage rates and borrowing costs to increase as well. According to Case and Shiller (2003), a contractionary monetary policy dampens expected inflation which in turn increases the user cost of housing. Higher user costs will reduce demand thereby, causing a drop in prices and output. From the supply side, it will have an immediate effect on the construction cost, causing output to decline.

Contractionary monetary policy shocks have significant negative effects on real GDP, residential investment and house prices in the US (Jarocinski, Smets, 2008). Applying the same shocks to the Australian housing sector, it was observed that changes in policy rates do not always reflect in the housing lending rates (Wadud, Bashar, Ahmed, 2012). Results of their study (Wadud, Bashar, Ahmed, 2012) also indicated that a contractionary monetary policy reduces housing output but does not really have a significant negative effect on house prices which had the same conclusion as Haug, Karagedikli and Ranchhold (2005).

With interest rates at the record lows and growth picking up quite well, the risk is when the RBA decides to hike rates. Households’ disposable income decreases as more of it is allocated to repayments. Financial stress can be felt from an increase in repayments more so in lower income households than from those who have higher disposable incomes. According to the RBA, arrears rates remain very low and over the past decade, households have already built prepayments in offset accounts and redraw facilities.

2. Inflation

A contractionary monetary policy shock is found to help reduce inflation rate meanwhile a positive inflationary shock which is likened to an adverse supply shock can reduce the real economic activity such as building of new houses in the economy and thus, decreasing housing outputs (Wadud, Bashar, Ahmed, 2012). Their study revealed that the RBA’s inflation targeting strategy may actually indirectly boost the Australian housing market resulting to more outputs.

3. House Prices

House prices can impact aggregate demand and economic activity in several ways. Increases in property prices are more inclined to have a positive effect on real GDP in many countries (Zhu 2003). First, it can lead to expectations of capital gains in property investments. When demand increases, builders start new construction creating employment and consumption. Second, private consumption also increases as home owners feel wealthier therefore, boosting demand for property related industries. In as much as price hikes can increase the wealth of existing homeowners, it also reduces the affordability of those who want to buy their own homes. They would have to take out a larger loan and commit to higher mortgage payments. Consumption then drops as a result. Affordability problems were generally observed in lower-income home purchasers. Richards (2008) argues that if housing is thought of as purely a consumption item then, a price hike would make the population in aggregate worse off. Increased housing prices and rents would shrink people’s spending power to consume all other services across all income structures.

If house prices in Australia are overvalued and price suddenly drops, the implications will be far worse than if the stock market collapses. Rahman (2010) presents three arguments as to why this is so. Firstly, a house is a large part of a household’s wealth compared to shares. If a person is suddenly less wealthy, consumption and the aggregate economic activity decreases and the risk of an economic recession increases. Secondly, borrowers may abruptly curtail their consumption when they are caught between falling house prices and rising rates. Lastly, households may end up having negative equity which means they owe more on their mortgage loan than the current market value of their homes. If mortgage defaults rise, lending capacity by banks for all purposes will tighten which can negatively affect the economy (Berry, Dalton, 2004).

V. The Role of RBA

The RBA has been doing its job to keep the country’s high resilience reputation intact. Financial stability is still the core of its business as the housing market woes continue to raise concerns. The level of household debt does not appear to be a risk to them but rather, the implications to the economy once households trim their consumption as they feel their financial positions are less secure.

Over the past few years, the housing market has slowed partly reflecting the prudential measures undertaken by APRA and ASIC. Tighter lending standards and strong serviceability metrics were implemented by financial institutions. The changes affected the borrowers least able to afford a loan and in effect, fewer households will struggle to service their debt should they experience any shock. In a positive macroeconomic environment setting, prices already eased by a small amount relative to the large increase in the preceding years. RBA is concerned more about a rapid correction in prices for them to consider it disruptive for the financial system and household balance sheets. Moderation in demand and supply dynamics has weighed on prices recently. Capital controls in China and state taxes on foreign buyers curbed demand while new dwellings increased supply. Since 2015, APRA has also required banks to improve their calculation of “Net Income Surplus” (NIS) to ensure that households have adequate buffers in an event of a shock (RBA Financial Stability Review October 2018). This means that a borrower who has maxed out its loan would still have some spare income after expenses and loan repayments. Therefore, tighter lending standards has dampened demand overall but has actually improved the resilience of households. The policies implemented by APRA, ASIC and RBA have helped reduce financial instability and increase consumer confidence.

VI. Conclusion

Debt only becomes a problem when the risk of default is high and in the case of a mortgage, the asset becomes a forced sale. Looking at it in a wider scale, a ripple effect throughout the economy can happen. People and firms will lose confidence in the economy and the financial sector. House prices will tumble, jobs are lost and the economy experiences a downturn (NATSEM 2015). High levels of debt increase the sensitivity of future consumer spending to certain shocks (Lowe, 2017). In Australia’s case, most of the debt are in the wealthy sector which means they have high levels of disposable incomes.

The RBA also plays a vital role in responding to this issue. It focused on strengthening the country’s resilience to future shocks which reinforced its stability. Banks are now soundly capitalized and are resilient to large price movements in properties. It has also slowed the pace of increase in household indebtedness by supporting the prudential measures undertaken by APRA and ASIC. Acknowledging that current households have debts that grow faster than its income makes the country less resilient to shocks.

With the arguments stated above, I personally believe that private sector debt in Australia will cripple any prospects of long-term growth if present conditions are altered. The arguments mostly dealt with the household debt in general but the same conditions apply to private firms as well. Conditions that decreases a person’s disposable income will constrict consumption and spending from consumers thus slowing growth. Factors that can hamper the growth of the Australian economy include a sharp increase in interest rates, stagnant or low wage growth, rise in unemployment, unpredictable inflation, sudden drop in house prices and a downturn in the economy.

In any case, just like how Australia was able to escape past crises, I am pretty confident that the government and the central bank had already anticipated, did stress tests and imposed measures to counter those factors even before it starts manifesting in the economy. They will not allow the private sector debt to reach a point that will impede long-term growth, so trust the system and don’t fret over debt.

VII. References

ABELSON, P., JOYEUX, R., MILUNOVICH, G. and CHUNG, D. (2005). Explaining House Prices in Australia: 1970-2003*. Economic Record, 81(s1), pp.S96-S103.
Berger-Thomson, L., & Ellis, L. (2004). Housing construction cycles and interest rates. Reserve Bank of Australia Research Discussion Paper, No. 08.
Berry, M. and Dalton, T. (2004). Housing prices and policy dilemmas: a peculiarly Australian problem?. Urban Policy and Research, 22(1), pp.69-91.
Bullock, M. (2018). The Evolution of Household Sector Risks. [online] Reserve Bank of Australia. Available at: https://www.rba.gov.au/speeches/2018/sp-ag-2018-09-10.html [Accessed 19 Nov. 2018].
Bullock, M. (2018). Household Indebtedness and Mortgage Stress. [online] Reserve Bank of Australia. Available at: https://www.rba.gov.au/speeches/2018/sp-ag-2018-02-20.html [Accessed 19 Nov. 2018].
Case, K. and Shiller, R. (2018). Is There a Bubble in the Housing Market?. [online] Available at: https://www.researchgate.net/publication/4909875_Is_There_A_Bubble_in_the_Housing_Market [Accessed 22 Nov. 2018].
Haug, A., Karagedikli, Ö. and Ranchhod, S. (2005). Monetary policy transmission mechanisms and currency unions. Journal of Policy Modeling, 27(1), pp.55-74.
Kent, C., Ossolinski, C. and Willard, L. (2007). The Rise of Household Indebtedness. [online] Reserve Bank of Australia. Available at: https://www.rba.gov.au/publications/confs/2007/kent-ossolinski-willard.html [Accessed 19 Nov. 2018].
Letts, S. (2018). People are spending their savings and it’s boosting the economy. [online] ABC News. Available at: https://www.abc.net.au/news/2018-09-05/gdp-june-quarter-2018/10202834 [Accessed 22 Nov. 2018].
Lowe, P. (2018). Household Debt, Housing Prices and Resilience. [online] Reserve Bank of Australia. Available at: https://www.rba.gov.au/speeches/2017/sp-gov-2017-05-04.html [Accessed 19 Nov. 2018].
NATSEM (2015). Buy Now, Pay Later. Income and Wealth Report Issue 38. [online] NATSEM at the University of Canberra. Available at: https://www.natsem.canberra.edu.au/publications/search-by-type/?publication=ampnatsem-income-and-wealth-report-issue-38-buy-now-pay-later [Accessed 22 Nov. 2018].
Rahman, M. (2010). The Australian housing market – understanding the causes and effects of rising prices. Policy Studies, 31(5), pp.577-590.
Reserve Bank of Australia (2018). Financial Stability Review. October 2018. [online] Reserve Bank of Australia. Available at: https://www.rba.gov.au/publications/fsr/2018/apr/overview.html [Accessed 19 Nov. 2018].
Richards, A., 2008. Some observations on the cost of housing in Australia. 2008 Economic and social outlook conference, 27 March. The Melbourne Institute, Melbourne
Smith, D. (2018). [online] Dicksmithfairgo.com.au. Available at: https://www.dicksmithfairgo.com.au/wp-content/uploads/2018/01/Debt-Paper-
Brochure_Screen-1.pdf [Accessed 19 Nov. 2018].
Stewart, C., Robertson, B. and Heath, A. (2013). Trends in the Funding and Lending Behaviour of Australian Banks. [online] Reserve Bank of Australia. Available at: https://www.rba.gov.au/publications/rdp/2013/pdf/rdp2013-15.pdf [Accessed 19 Nov. 2018].
Tang, E. (2018). 2017-18 GDP growth rate of 2.9 per cent confirms the resilience of our economy. [online] Austrade. Available at: https://www.austrade.gov.au/news/economic-analysis/2017-18-gdp-growth-rate-of-2-9-per-cent-confirms-the-resilience-of-our-economy [Accessed 19 Nov. 2018].
TradingEconomics. (2018). Australia Private Debt to GDP | 2018 | Data | Chart | Calendar | Forecast. [online] Available at: https://tradingeconomics.com/australia/private-debt-to-gdp [Accessed 22 Nov. 2018].
Wadud, I., Bashar, O. and Ahmed, H. (2012). Monetary policy and the housing market in Australia. Journal of Policy Modeling, 34(6), pp.849-863.
Zhu, H., 2003. The importance of property markets for monetary policy and financial stability. Conference paper, IMF-BIS conference on real estate indicators and financial stability, 27-28 October 2003, Washington, DC. International Monetary Fund (IMF).